Monday, November 24, 2008

This chart is a good way to judge the depths of the market's recent despair. 10-year Treasury yields last week fell to 3%, which was the level they traded at during the early years of the Great Depression. 2-year Treasury yields fell to 1% last week, which implies that the market expects the Fed funds rate to average 1% (it is 1% now) for the next two years; presumably this means the Fed will cut rates to 0.5% at its next meeting, then keep them there for a long time before slowly raising rates to 2-3% some 18 months from now. In short, Treasury yields are telling us that the market holds virtually no hope for any meaningful economic recovery in the next few years, and is powerfully concerned that we are in for a repeat of the Depression of maybe even worse.

With fear so enormous and yields so incredibly low, an investor knows that the market is extremely vulnerable to any positive surprises. If things don't prove to be disastrous, then equity prices are likely to rise and Treasury yields are likely to rise. Indeed, owning cash, Treasury notes, or Treasury bonds is one of the riskiest things I can think of in this environment. You earn almost nothing in interest, and you could potentially suffer huge losses if the economy experiences even a modest recovery (because yields could rise significantly, pushing Treasury prices lower, while other things you don't own rise in price). As an example, the news that Obama is picking economic advisors (more on this in a subsequent post) that are smart and experienced (as opposed, I suppose, to mindless idealogues) was enough to push 10-year Treasury prices down by 3% in the past two trading sessions—enough to wipe out a year's worth of interest! Over the same two-period, the S&P 500 index is up 10%.